According to the U.S. Tax Court, a "short sale" of real estate generates taxable income to the extent of the excused unpaid mortgage. As a result, a taxpayer must include income from the discharge of indebtedness on his/her Federal Income Tax Return. The reporting process following a short sale begins after an applicable entity discharges the indebtedness of any person, in an amount of $600 or greater, during a calendar year. Once such indebtedness is discharged, the lender must file a 1099-C Form with the IRS and issue a copy to the borrower. Taxpayers must then report all form 1099-C income on their returns, unless they qualify under an exception and file the required IRC 982 Form.

One exception to the general rule requiring a taxpayer to include income from the discharge of indebtedness on his Federal Income Tax Return allows a taxpayer to exclude taxable income generated from a short sale if the indebtedness discharged is qualified principal residence indebtedness discharged before January 1, 2014. Accordingly, to qualify for this exception the following conditions must be met: (1) the property sold in the short sale is the taxpayer's principal residence, as used in IRC §121; (2) the cancellation of debt is Qualified Principle Residence Indebtedness under IRC §163(h)(3)(B); and (3) the debt is forgiven on or after January 1, 2007, and before January 1, 2014.

All facts and circumstances should be applied to determine whether a residence is a taxpayer's "principal residence." If a taxpayer alternates between 2 properties, using each as a residence for successive periods of time, the property that the taxpayer uses a majority of the time during the year ordinarily will be considered the taxpayer's principal residence. Further, the term "qualified residence interest" means any interest which is paid or accrued during the taxable year on (i) acquisition indebtedness with respect to any qualified residence of the taxpayer, or (ii) home equity indebtedness with respect to any qualified residence of the taxpayer.

The term "acquisition indebtedness" means any indebtedness which is 1) incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and (2) secured by such residence. The aggregate amount treated as acquisition indebtedness for any period shall not exceed $1,000,000 ($500,000 in the case of a married individual filing a separate return). It is important to note that acquisition indebtedness does not include home equity loans used to pay off credit cards, purchase a car, or pay medical bills etc.

The term "home equity indebtedness" means any indebtedness (other than acquisition indebtedness) secured by a qualified residence to the extent the aggregate amount of such indebtedness does not exceed the fair market value of such qualified residence, reduced by the amount of acquisition indebtedness with respect to such residence. The aggregate amount treated as home equity indebtedness for any period shall not exceed $100,000 ($50,000 in the case of a married individual filing a separate return).

Also, note that special rules apply to Pre-1987 indebtedness.

For the above exemption to continue, Congress has to extend the exemption provision prior to its expiration. Otherwise, starting Jan. 1, 2014 a taxpayer must include income from the discharge of indebtedness on his/her Federal Income Tax Return.

The law firm of DeLoach, Hofstra & Cavonis, P.A., does not specialize in tax law and any individual seeking to employ the above exceptions should seek independent counsel and advice pertaining to tax ramifications.